Tractor Supply Company (NASDAQ:TSCO) just gave investors a nice raise last month. The stock's $0.27 quarterly dividend represents a 12.5% increase from its previous rate of $0.24 per share. Last month's raise marks the seventh consecutive year of dividend increases for shareholders. While that streak may not be as impressive as some of its competitors, such as Lowe's (NYSE:LOW) and its 54-year streak, every dividend payer has to start somewhere.
Still, Tractor Supply Company's dividend yields just under 2% on its current share price, which is comparable to Lowe's but still nothing to write home about. That's why it's important to take a closer look at the potential for management to continue raising its dividend year after year, as it has for the past seven years.
Management's commitment to dividend growth
One of the biggest keys to a growing dividend is management's commitment to keep increasing the payout year after year. While Tractor Supply Company doesn't have a huge streak of dividend increases to keep it accountable, its priorities nonetheless appear to be in the right places.
The company has a defined capital-allocation strategy, which CFO Kurt Barton outlined at the company's Investment Community Day earlier this year.
- The company plans to devote $250 million to $300 million annually to grow the company through new store openings and acquisitions, such as the Petsense acquisition it made last year.
- It's committed to paying a dividend, targeting roughly a 30% payout ratio.
- It plans to repurchase between 2.5% and 3.5% of shares every year, which translates into $300 million to $400 million annually.
With just $639 million in operating cash flow during 2016, some investors may think the capital allocation strategy is too aggressive. But consider that Tractor Supply Company has access to a $200 million term loan, a $500 million revolving credit line, and a $300 million accordion option, for a total of $1 billion. Considering the company is underleveraged compared with Lowe's and Home Depot (NYSE:HD), management has plenty of room to increase its financial leverage to grow the company and return capital to shareholders at the same time.
Dividends come from earnings. Will they grow?
Starting with the top line, Tractor Supply should be able to sustain "high-single-digit sales growth," as outlined at its Investment Community Day. Growth of 7% to 9% would come from a 2% to 3% increase in comparable-store-sales growth and 5% to 7% from new store openings.
The 2% to 3% comparable-sales growth is what management provided in its 2017 outlook, which would be a big step up from 2016, when it reported just 1.6% increase comparable sales. The first quarter got off to a rocky start because of extreme weather conditions that affected sales in a good way in 2016 and a bad way in 2017. Still, same-store sales should be supported by its new loyalty program, Neighbor's Club, as well as initiatives to increase consumable product sales, driving repeat customers.
Meanwhile, the company plans to open 100 new Tractor Supply stores per year, which averages about 5% new stores per year over the next decade, and increase Petsense storefronts 15% to 20% per year.
Along with strong sales growth, the company should be able to improve margin in the long term. Increasing private-label product selection should result in higher gross margin and translate into better customer loyalty as well. That should help offset the focus on relatively low gross-margin consumables. In addition, the company should see improved pricing power as it gains scale.
Overall, the company expects to see operating-margin expansion of 15 to 25 basis points per year. It expects that improvements in energy and expense management and greater marketing efficiency as it adds stores will help offset increased investments in supply-chain infrastructure and the online ordering platform.
Finally, the company's bottom line may be positively affected by favorable changes to the tax code, and as mentioned, the company is also planning on buying back 2.5% to 3.5% of outstanding shares every year. Putting it all together results in earnings-per-share growth of 11% to 14% over the long term. This may be a somewhat conservative outlook, as the Wall Street consensus estimate is for 15% EPS growth over the next five years.
So just how much can the dividend grow?
In 2016, Tractor Supply Company paid out 28% of its earnings in dividends, and it's on pace to pay out 30% of its earnings in 2017 based on the $3.48 midpoint of its 2017 earnings-per-share outlook. So it would be reasonable for Tractor Supply Company to sustain dividend growth right in line with earnings at 11% to 14% per year, which is in line with the most recent dividend increase.
It's important to note, however, that Tractor Supply Company can afford to pay out more than 30% of its earnings as a dividend if it wanted. It produces a return on equity of about 33%, and with maximum organic growth of around 9% annually, it needs to retain only about 28% of earnings to continue growing its business. What's more, it has room to increase its financial leverage, which would increase return on equity, freeing up more cash to return to shareholders.
Both Lowe's and Home Depot use much more leverage for their businesses and have payout ratios of about 35% and 50%, respectively. Somewhere in the middle seems like a more appropriate long-term payout ratio for Tractor Supply Company, especially as it reaches scale and requires a lower percentage of earnings to open new stores. At that point, however, earnings growth may be slower.
As such, Tractor Supply Company should be able to sustain a low-teens dividend growth rate for a long time.